Efficiency of weather derivatives for Chinese agriculture industry

Abstract

Purpose – The purpose of this paper is to analyze the efficiency of temperature-based weather derivatives (WD) in reducing risk exposure for Chinese agriculture industry. Therefore, a put option with cumulated growing degree days as its underlying index is assumed to be bought by farmers as a risk management instrument to prevent income fluctuations from adverse temperature conditions. Design/methodology/approach – The objective of this paper is to analyze the efficiency of temperature-based WD in reducing risk exposure for Chinese agriculture industry. Therefore, a put option with cumulated growing degree days as its underlying index is assumed to be bought by farmers as a risk management instrument to prevent income fluctuations from adverse temperature conditions. Findings – The results of the efficiency tests show that temperature-based put options are efficient in offsetting yield shortfalls for rice and wheat in China. The weather-yield models have a high prediction power in explaining yield variation by temperature. Research limitations/implications – The de-trending procedure for the weather-yield model should be improved to distinguish better between technology progress, human activities and influence of weather. Further, more advanced models could be used for the pricing. Practical implications – The findings of the paper support the launch of WD as an efficient risk management tool for agriculture in China. Compared with traditional damage-based insurance, WD are more flexible, have lower transactions costs and avoid moral hazard or adverse selection. Originality/value – The efficiency problem of WD has not been analyzed sufficiently worldwide and especially not for developing countries like China where a large proportion of the population works as farmers. This paper supports to fill this gap.